Lecture 3: more formal models of decision making Flashcards
Gamble paradigm
making rational choices in simple gambles.
gambles are often used to research decision making, because many choices we make in our daily life can be modelled as gambles.
Null-bet
a gamble that will eventually result in 0 (for example flipping a coin a lot of times and either winning or losing 5 euro’s).
Law of large numbers
if you choose the option with the highest EV for all the choices you make you’ll come out best.
as number of plays inncreases, the mean payoff converges to the EV.
EV principles
- Expected valuechoice principle = makes decision making easy even though the calculations are hard; choose the alternative with highest EV.
- Expected value evaluation principle = the value of an alternative is equal to its EV; think about how much something is worth to you
Cramers first explanation for the st. Petersburg paradox
why don’t people offer infinite amounts of money?
any amount beyond 20 milion does not add value, because it doesn’t make people happier. therefore the expected amount offered would be 13 if you do the math.
- The problem here was the assumption about value and change what it means. so bernoulli dismissed Cramers first attempt
Cramers second attempt at explaining the st. Petersburg paradox
the value of a unit will decrease as wealth increases and the value follows the square root of wealth. his math then added up to about 2,91.
- however, he still changes the meaning of value.
Bernoulli’s own attempt at solving the st. petersburg paradox
proposed that the gambler disregards small probabilities. he sets all probabilities beyond 1/32 to zero and his calculations gave him an expected value of €2,50.
how and by whom was the st. Petersburg paradox eventually solved
Bernoulli’s cousin solved it.
according to him the utility of wealth follows the logarithmic function, so the utility resulting from a small increase in wealth is proportional to the quantity of the goods already possesed. Therefore we should use utility instead of value
similair to Cramers first idea, but doesn’t stop just becomes less
25 years after bernoulli’s original letter to Montmort with the proposed problem.
utility
subjective value; refers to life satisfaction, enjoyment etc.
that is what we are supposed to maximize.
two things that determine what people do in simple economics
- pleasure
- price
Related to Bentham
Jevons, Walras, Menger en Marshall
developed mathematical theories in economics based on the idea that utility is a psychologically real entity.
Kahneman, Wakker & Savin
distinguished two types of utility
- decision utility: anticipated pleasure you feel at the time of decision
- experienced utility: pleasure you actually feel from the consequence of your choice.
two ways to measure utility
- Total utility = refers to the satisfaction you get from the consumption of a product
- Marginal utility = refers to the satisfaction you get from the consumption of one additional unit of a product above and beyond what you’ve already consumed.
the principle of diminishing marginal utility
after some point the marginal utility recieved from each additional unit of a good decreases with each additional unit consumed.
risk aversion
people have a preference for certainty, because getting 50 euro’s leads to more utility than the change of having 100 euro’s.
